What drives the price of oil?

In an exclusive interview, the economist James D. Hamilton gives his reading of the oil price spike in 2007-08 and what lies ahead of us. “Acknowledging honestly the size of the challenge is probably the most important first step.”

By Lars Schall

James D. Hamilton, born 1954, received his Ph.D. in Economics from the University of California at Berkeley in 1983. He has been a professor at the Department of Economics, University of Virginia from 1987 – 1992, a professor of economics at University of California, San Diego since 1992 and served as Chair of the Economics Department at UCSD from 1999 to 2002.

His primary fields of teaching are macroeconomics,  econometrics and energy economics. He has done extensive research on business cycles, monetary policy and oil shocks, and has frequently been a research adviser and visiting scholar with the Board of Governors of the Federal Reserve as well as individual Federal Reserve banks.

One of his research interests concerns oil price shocks and he discussed some of the issues of interest in testimony before the Joint Economic Committee of the United States Congress on May 20, 2009. His latest research paper on this topic is Causes and Consequences of the Oil Shock of 2007-08, which was presented at a conference at the Brookings Institution on April 2, 2009.

Mr. Hamilton is the author of Time Series Analysis (Princeton University Press, 1994), the leading text on forecasting and statistical analysis of dynamic economic relationships, and Advances in Markov-Switching Models (Physica-Verlag, 2002; co-edited with Baldev Raj). He published scientific papers and articles at Journal of Money, Credit, and Banking, Journal of Monetary Economic, Macroeconomic Dynamics, Energy Journal.

Among his current working papers are:

Calling Recessions in Real Time,

Nonlinearities and the Macroeconomic Effects of Oil Prices,

The market-perceived monetary policy rule, co-authored with Seth Pruitt and Scott Borger,

Sources of Variation in Holding Returns for Fed Funds Futures Contracts, co-authored with Tatsuyoshi Okimoto.

Mr. Hamilton, one of your research interests as an economist concerns the economic consequences of oil price shocks. What exactly is an oil price shock?

Traditionally these resulted from dramatic geopolitical events that substantially disrupted global oil supplies, such as the embargo by the Organization of Arab Petroleum Exporting Countries in 1973, the dual disruptions of the Iranian revolution in 1978 and the Iran-Iraq war in 1980, and the first Persian Gulf war in 1990.  However, in 2007-2008 the price of oil increased as much or more as in any of these previous episodes, in the absence of any major disruption in the supply.  I believe that the most recent episode had similar consequences for the economies of the oil-consuming countries as the earlier oil shocks.

A good example how high oil prices can affect the economy in a negative way was the oil price spike of 2007/08. You have written on this topic a research paper entitled Causes and Consequences of the Oil Shock of 2007-08. What were the major factors contributing to the soaring oil price in your view?

Global oil production was basically stagnant between 2005 and 2008, while the world economy and demand for oil grew at a very rapid pace.  For example, consumption of oil in China grew by over a million barrels per day between 2005 and 2007, and yet no more oil was being produced.  This required consumers in Europe, Japan, and the United States to reduce their consumption of oil by about a million barrels per day.  It turned out that an enormous increase in the price was necessary to bring about that kind of reduction in the quantity demanded from the OECD countries during a period of economic growth.

Can you give our readers clear evidence for the economic correlation between the tightening of oil / energy on the one side and the current financial crisis on the other?

The most dramatic episode in the financial crisis came after the failure of Lehman Brothers in September 2008.  However, in the year leading up to this, many of the developments observed in the U.S. economy were quite similar to what had happened with earlier oil shocks.  For example, in early 2008, sales of large SUVs plunged even as sales of more fuel-efficient imported small cars were rising.  The fall in income and employment in the U.S. auto sector was comparable to that seen in earlier oil shocks, and much of the decline in consumer sentiment and slowdown in consumer spending that occurred before the summer of 2008 were very similar to what happened in earlier oil shocks.  Certainly oil prices were not the only factor in producing the events of September 2008, but just as certainly they made a measurable contribution.  Falling income and rising unemployment can only exacerbate the incidence of mortgage delinquencies.

One application of your research has been to determine via algorithms when economic recessions begin and end. Is there a limit of the oil price from which on it will become impossible to make growth and thereby a recovery happen?

I believe that the big macroeconomic effects that followed historical oil shocks resulted from recessionary feedback dynamics in which unemployed workers cut their spending on other products.  But once we reach that condition, we’re in some ways insulated from an immediate repeat of the same process.  For example, U.S. auto sales at the moment are still at such a low level.  Purchases have been postponed for sufficiently long that I would be very surprised to see higher oil prices responsible for another big shock to that sector under current conditions.  So I really don’t look to oil prices as a logical cause of a double-dip recession.

You also focus on monetary issues. Is there a problem coming our way due to the apparent scarcity of the energy supply and the way our money system works? Are both things on a collision course with each other?

The basic issue is that consumers wanted oil that just wasn’t available– the million barrels per day I mentioned above.  The U.S. Federal Reserve and the European Central Bank can create lots of money, but do not have the power to produce a single barrel of oil. It is a mistake to think that a sufficiently clever monetary policy could solve the problem.

There is nevertheless a potential for destabilizing feedback here.  As the oil-producing countries accumulated a dollar surplus, some of that money went back into investments that were really not too sound.  Bernanke has referred to this as a “global savings glut”, while others have described it as investors “chasing yield.”  Whatever you want to call it, this interacted with an over ambitious monetary policy to keep interest rates at excessively low levels over 2003-2005.  The resulting poor investments again made a contribution to the financial crisis.

How could this collision course being ended? For example through energy vouchers? May I ask you to explain how such a system functions?

I believe we have come to expect too much for monetary policy, and would do better to simply acknowledge that the energy issues are not ones we can address with this tool.  Unfortunately, I do not think there is any simple fix– energy vouchers or any other– for the looming challenges ahead in terms of energy.  But acknowledging honestly the size of the challenge is probably the most important first step.

Do you see derivatives as a prime problem in the oil market today?

Again, I think it is most helpful to first look at the physical quantities of oil that are being produced and consumed.  The underlying policy challenge here is a physical, not a financial matter.

Should the U.S. Commodity Futures Trading Commission, CFTC, step in much more as an aggressive regulator?

Yes, I think there are a number of issues, including participation by pension funds, off-exchange speculation, margins, and counterparty and systemic risk on which regulatory oversight has been insufficient.

What drives the oil price right now? In Germany there is a widespread perception that we are seeing grotesque exorbitant prices at the gas stations caused by sheer speculation and rip-off from the oil companies.

The international oil companies are far less important today than they were half a century ago.  For example, ExxonMobil, the biggest, had 2.4 million barrels per day of liquids production in 2009, which is less than 3% of the 84 mbpd world total.  Production today is in the control of sovereign countries like Saudi Arabia, not private oil companies.

And as for speculation, I would again have thought the focus should first be on financial speculators and possible physical accumulation by China rather than actions of any oil companies.

Although perception such as you describe may be widespread, I am unaware of hard facts that one could point to in its support.

What are your thoughts related to what is happening in the Gulf of Mexico as the result of the Deepwater Horizon explosion?

The companies here were trying to drill for oil through several miles of rock and under 5000 feet of water.  While that is a pretty impressive feat of engineering, this tragedy drives home the reality that we have very little ability to control what happens in those circumstances or respond to problems.  We are sometimes lulled by the apparent dazzling success of our technology in some arenas into forgetting or ignoring the many things that can and will go wrong.

Do you agree with Michael T. Klare that “more such disasters will follow” because “the ultimate source of the disaster is big oil’s compulsive drive to compensate for the decline in its conventional oil reserves by seeking supplies in inherently hazardous areas”?[1]

About a third of U.S. field production of oil now comes from offshore sources, whereas 30 years ago, offshore production was relatively inconsequential.  And that increase in offshore production has coincided with a dramatic trend of declining total U.S. production.  Why are we trying to extract oil in such inherently difficult-to-control circumstances?  Because that’s where the remaining oil is to be found.

Why is there in the United States a lot of lip-service with regard to renewable energy sources but little concrete action?

A third of America’s corn crop is now devoted to ethanol production.  This is not something to brag about, since I think it is a terrible resource waste, but it is certainly not just lip service.  Electricity production from renewables has increased 36% over the last decade, but is still only 5% of the total.  Natural gas is relied on more for electricity generation because it is cheaper.  But the real issue for U.S. oil demand is transportation, not electricity generation, and to get away from oil as a transportation fuel requires some major infrastructure investments, which is a separate issue from developing renewable energy sources.

Would you support the implementation in the U.S. of a national Feed-in Tariff mandating that electric utilities pay 3 % above market rates for all surplus electricity generated from renewable sources, as Mike Ruppert suggests in his new book “Confronting Collapse”?[2] Why could this make good economic sense?

I believe it makes more sense to tax the specific energy sources you want to discourage.

Thank you very much for taking your time, Mr. Hamilton!


[1] compare Michael T. Klare: “The Oil Rush to Hell / The Relentless Pursuit of Extreme Energy. A New Oil Rush Endangers the Gulf of Mexico and the Planet, veröffentlicht auf Tom Dispatch am 18. Mai 2010 unter:


[2] compare Michael C. Ruppert: “Confronting Collapse. The Crisis of Energy and Money in a Post Peak Oil World. A 25-Point Program for Action”, Chelsea Green Publishing, December 2009.

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